Oct 16, 2018 | 15:55 GMT

4 mins read

Italy: Rome Challenges the European Union with Plan to Increase Its Budget Deficit

The Big Picture

In Stratfor's Fourth-Quarter forecast, we said Italy's new government would change the direction of its policy from reducing its deficit to increasing it — and we anticipated that the European Commission and financial markets would react negatively to these developments. Events in recent weeks have confirmed this forecast, and while Italy's membership in the eurozone is not currently at risk, Rome and Brussels will continue to clash over Italy's fiscal plans, challenging market stability.

What Happened

Italy is bracing itself for a clash with the European Commission over its spending plans. On Oct. 15, the Italian government went to Brussels to present its budget proposals, which call for a deficit increase of 2.4 percent of gross domestic product (GDP) in 2019 — significantly higher than the 0.8 percent that the European Union was expecting. The deficit will come as a result of measures such as the introduction of a monthly income of up to 780 euros ($905) for low-income citizens and the lowering of Italy's retirement age. While Rome promises that the measures will generate so much economic growth that Italy's deficit will decrease starting in 2020, Brussels and financial markets are skeptical.

What's Next

The commission now has two weeks to comment on Italy's plans, and several commissioners have indicated that Brussels will ask Rome to make amendments. After Italy receives the commission's requests, which will occur by late October, it will have three weeks to submit an updated budget proposal. But the Italian government has repeatedly said it will not back down. If this is the case, the commission will have to decide by late November whether to start the Excessive Deficit Procedure, a mechanism to pressure countries to keep their deficit levels in line with EU targets.

The procedure is a long process in which countries are given several opportunities to comply with EU rules before facing sanctions, which could range from financial penalties of up to 0.5 percent of the country's GDP to suspension of the country's access to EU funds. It could be months, if not years, before Rome faces penalties. And ultimately, member states decide whether or not to impose sanctions through reverse qualified majority voting, meaning the penalties are approved unless a qualified majority of governments blocks them.

Why It Matters

While the commission has started Excessive Deficit Procedures against several EU members in the past, the parties involved have always compromised in order to avoid sanctions. But the situation with Italy is particularly high-profile, as Rome has openly challenged Brussels' rules in ways other governments have not. Every previous compromise between Brussels and a member state has put the commission's credibility at risk to some degree, but Italy has made it especially hard for the institution to back down.

What It Means for Financial Markets

Financial markets are relatively calm this week, suggesting investors may have already factored Italy's uncertainty into current interest rates. But this situation cannot be taken for granted. Italy's borrowing costs have increased in recent months, while the spread between Italy's bonds and Germany's (which are considered the safest in Europe) has broadened. Over time, this could make it more expensive for the Italian government to finance itself, while a decrease in the price of Italian debt could damage the balance sheets of the country's banks, which hold billions of euros in Italian debt.

In addition to the upcoming assessment by the European Commission, markets will also be looking at credit ratings agencies. S&P will release its assessment of Italy on Oct. 26, and Moody's Corporation is expected to release its review around the same time. A negative assessment by either of these companies will probably add to financial pressure on Italian debt.

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